equitable subordination and recharacterization of loans...

Equitable Subordination and Recharacterization

of Loans: Avoiding Pitfalls for Lenders, Creditors,

and PE Sponsors

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.

WEDNESDAY, MARCH 4, 2020

Presenting a live 90-minute webinar with interactive Q&A

Eric W. Anderson, Partner, Parker Hudson Rainer & Dobbs, Atlanta

Ira L. Herman, Partner, Blank Rome, New York

Gary M. Kaplan, Partner, Farella Braun + Martel, San Francisco

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-877-447-0294 and enter your Conference ID and PIN when prompted.

Otherwise, please send us a chat or e-mail [email protected] immediately

so we can address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the ‘Full Screen’ symbol located on the bottom

right of the slides. To exit full screen, press the Esc button.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 2.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the link to the PDF of the slides for today’s program, which is located

to the right of the slides, just above the Q&A box.

• The PDF will open a separate tab/window. Print the slides by clicking on the

printer icon.

FOR LIVE EVENT ONLY

Equitable Subordination

Eric Anderson & Matthew Weiss

Parker Hudson Rainer & Dobbs LLP

March 4, 2020

Evolution of Equitable Subordination

© 2020 Parker Hudson Rainer & Dobbs LLP. All Rights Reserved. 6

In bankruptcy, claims or interests generally fall into one of the following classes:

Administrative Claims

Secured Claims (to the extent of the value of the collateral)

Unsecured Claims

Equity Interests

Equitable subordination occurs when a court applies equitable reasons to alter the general distribution scheme provided under the Bankruptcy Code.



Pre-Code Supreme Court Cases

Taylor v. Standard Gas & Electric Company, 306 U.S. 307 (1939):

Where actions of corporate parent were responsible for insolvency of subsidiary, corporate parent’s bankruptcy claim was subordinated to the interests of the subsidiary’s other stockholders.

Pepper v. Litton, 308 U.S. 295 (1939):

Where the controlling stockholder of a company made a salary claim against the company’s bankruptcy estate, the district court correctly disallowed the claim where it had lied dormant for years and was only enforced when the debtor was in financial difficulty. The Supreme Court found that the stockholder was perpetrating a fraudulent plan to defeat the other creditors of the corporation.

Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948):

A claim against a debtor subsidiary should be disallowed or subordinated when the parent wholly dominated and controlled the subsidiary and in creating the subsidiary’s debt to the parent breached its fiduciary duty and acted to its own benefit and to the detriment of the debtor.



11 U.S.C. § 510(c):

After notice and a hearing, the court may –

(a) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or

(b) order that any lien securing a subordinated claim be transferred to the estate.

Legislative History:

Congress envisioned the doctrine of equitable subordination would continue to evolve over time.

Equitable subordination claims are asserted in adversary proceedings



Common circumstances where courts apply equitable subordination:

Where a fiduciary abuses its position with the debtor to the disadvantage of other creditors.

Where a third party exercises control over the debtor, to the detriment of other creditors.

Where a third party defrauds other creditors or engages in other inequitable conduct that results in harm to creditors.

Equitable subordination is not mandatory.

Guiding principles:

Equitable subordination resets the regular distribution scheme to correct harm caused by inequitable or fraudulent conduct.

Serves a remedial purpose and only exists to the extent necessary to correct the harm caused.


Elements of Equitable Subordination

Mobile Steel Factors

Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th Cir. 1977) – this is considered one of the “landmark” cases on equitable subordination.

The claimant committed fraud or engaged in other inequitable conduct

The wrongdoer’s conduct harmed other creditors or gave the wrongdoer an unfair advantage

The subordination of the claim will not be contrary to or inconsistent with the principles of bankruptcy law

Satisfaction of Mobile Steel factors authorizes, but does not require, equitable subordination



1. “Claimant committed fraud or engages in other inequitable conduct”

Fraud, illegality and breach of fiduciary duties

Substitution of debt for capital when a company is undercapitalized; and

Claimant’s use of the debtor as its alter ego instrumentality.



Typical situations where a claimant has committed fraud or engaged in other inequitable conduct

Where a fiduciary of the debtor misuses his position to the disadvantage of other creditors.

Parties seeking equitable subordination must show, by a preponderance of the evidence, that they have a substantial basis in fact to support allegations of impropriety.

Insiders are subject to “rigorous scrutiny”. See, e.g., In re AutoStyle Plastics, Inc., 269 F.3d 726 (6th

Cir. 2001).

Insiders have the burden to establish both “the inherent fairness” and the “good faith” nature of the transaction being challenged.

A Non-Insider creditor must be found to have engaged in specific conduct that gives rise to a fiduciary, contractual, or other legally recognized duty to the other creditors before its claim will be equitably subordinated

Exception: “No Fault” Equitable Subordination - Equitable subordination of certain claims in limited cases (e.g., tax penalty claims) based upon the nature or origin of the claim, as opposed to the claimant’s conduct


Criminal Activity

Breaches of fiduciary duties

Actual fraud



Who is an insider?

Statutory Insiders

Specified in 11 U.S.C. § 101(31)

A director

An officer

A “person in control”

A general partner

A relative of an insider

An affiliate of the debtor at the time of the transaction to be avoided

Non-Statutory Insiders

Fact-specific judicial inquiry requiring:

A “close relationship” between the creditor and the debtor; and

A non-arms’-length transaction




Where an insider purchases claims against the debtor during bankruptcy (i) for the dual purpose of profit making and to exert influence over the reorganization; (ii) with the benefit of non-public information acquired as a fiduciary; and (iii) where the insider did not make adequate disclosure of its purchasing plans.

In re Papercraft Corp., 160 F.3d 982 (3d Cir. 1998)

Where an insider induced a creditor to extend credit despite knowing of a debtor’s failing financial condition and presented a fraudulent corporate resolution to open a new bank account to prevent an existing bank from exercising its right of setoff.

In re Fabricators, 926 F.2d 1458 (5th Cir. 1991)

Important to note that insider status alone is not sufficient to equitably subordinate claim. AutoStyle Plastics, 269 F.3d at 745.




Where a third party controls the debtor to the disadvantage of other creditors.

Has the debtor’s decision-making capacity been replaced with that of the lender?

Has the lender “exercise[d] . . . such total control over the debtor as to have essentially replaced its decision-making capacity with that of the lender?”

In re Clark Pipe & Supply Co., 893 F.2d 693 (5th Cir. 1990)

See also In re Heartland Chemicals, Inc., 136 B.R. 503 (Bankr. C.D. Ill. 1992)



Claimant’s Use of the Debtor as its “Alter Ego”

For non-insiders/non-fiduciaries, courts have generally not found “control” in the creditor’s exercise of its negotiated contractual rights.

A lender is held to a fiduciary standard only when it usurps the borrower’s ability to make business decisions

If a lender takes away a borrower’s authority to make business decisions, it must assume the fiduciary obligations the officers and directors owe to the corporation and its creditors

In re Auto Specialties Mfg. Co., 153 B.R. 457, 478 (Bankr. W.D. Mich. 1993)


Elements of Equitable Subordination Typical situations where a claimant has committed fraud or engaged in other

inequitable conduct

Evidence that a lender is exercising “control” over a borrower:

- Stock ownership - Interference with business operations- Participation in management decisions- Directing which creditors to pay- Placement of lender’s employees as directors and

officers- Hiring and firing personnel - Participation in shareholder meetings- Participation in management meetings- Whether scrutiny of the borrower’s financial affairs

turned into control of day-to-day management

- Dealing with the debtor at arms’-length- Debtor’s ability to disregard advice of

the lender- Whether loan was arms’-length bargain - Whether lender exceeded authority

under loan agreement- Whether borrower was required to hire

an outside manager- Whether “soft cost” assessed against

the borrower’s accounts were excessive

Limits on doctrine vis-à-vis lendersImportant to note that courts have recognized many legitimate exercises of rights and powers by lenders that do NOT rise to level of “control” and are not otherwise deemed to be inequitable conduct:

• See, e.g., In re American Consolidated Transportation Companies, Inc., 433 B.R. 242, 254 (Bankr. N.D. Ill. 2010)

– “In contrast, control is not established when a lender insists on standard loan agreement restrictions, closely monitors the borrower's finances, and makes business recommendations, even if the context of heated negotiations . . . Nor is control established when a borrower hires a management or restructuring consultant selected by the lender.” [citations omitted]

• Case involved, among other things, allegation that lender established control over borrower

by insisting that borrower retain a restructuring consultant. Court rejected that argument.


Limits on doctrine vis-à-vis lenders• See also In re Prima Co., 98 F.2d 953, 965 (7th Cir.), cert. denied, 305 U.S. 658 (1938):

– “Aside from the provisions of the bankruptcy law, a creditor has a right to call a loan when due and to lawfully enforce collection. He may refuse an extension for any cause which may seem proper to him, or even without any cause. The law provides certain means for the enforcement of claims by creditors. The exercise of those rights is not inherently wrongful.”

• In re Prince Frederick Inv., LLC, 516 B.R. 778 (Bankr. D. Md. 2014) (bank exercising approval rights on construction draws and change orders, as provided in loan documents, did not rise to level of exercising dominion and control over borrower).

• See generally Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990)(“Contracts specify the duties of the parties to each other, and each may exercise the privileges it obtained.”)




Undercapitalization

Occurs when insiders convert their equity interests to debt in anticipation of bankruptcy.

Initial undercapitalization generally does not support an equitable subordination claim

Generally additional inequitable conduct must occur during the course of a lending transaction

A finding of undercapitalization requires evidence of deception of the debtor’s financial position or other misconduct



Undercapitalization

Mobile Steel created a two-part test for establishing undercapitalization for equitable subordination:

(1) Capitalization is inadequate if, in the opinion of a skilled financial analyst, it would definitely be insufficient to support a business the size and nature of the bankrupt in light of the circumstances existing at the time the bankrupt was capitalized; and

(2) Capitalization is inadequate if, at the time when the advances were made, the bankrupt could not have borrowed a similar amount of money from an informed outside source


Elements of Equitable Subordination 2. “The Wrongdoer’s conduct harmed other creditors or gave the wrongdoer an

unfair advantage.”

Requires a showing of (1) unfair advantage to misbehaving creditors or (2) harm to the debtor or its other creditors.

A majority of courts only require a showing of one of these.

Good faith by a claimant will not negate harm caused to the debtor or its other creditors

The creditor who benefits from the subordination of the claim must be the creditor injured by the inequitable conduct

An injury occurs where there is inequitable conduct by a claimant close to a bankruptcy or while a debtor is in financial distress

Injury occurs where general creditors are less likely to collect their debts

Quantifying the harm is helpful to establish whether equitable subordination is proportional, but is not a requirement for equitable subordination


Elements of Equitable Subordination 3. “The subordination of the claim will not be contrary to the principles of bankruptcy law.”

Noland- Debtor could not deny first priority to non-compensatory, post-petition tax penalties under guise of equitable subordination

Court said third element is a “reminder to the bankruptcy court that although it is a court of equity, it is not free to adjust the legally valid claim of an innocent party who asserts the claim in good faith merely because the court perceives the result is inequitable.” United States v. Noland, 517 U.S. 535, 539 (1996)

Bankruptcy courts cannot reorder the priorities of the Bankruptcy Code based on categorical determinations that claims “by their very nature” deserve subordination

“The circumstances that prompt a court to order equitable subordination must not occur at the level of policy choice at which Congress itself operated in drafting the Code.” Noland, 517 U.S. at 543.

Some courts have questioned the continuing need for this prong in light of the codification of equitable subordination under the Bankruptcy Code

Availability of alternative remedies under the Bankruptcy Code and Bankruptcy Rules does not preclude equitable subordination


Equitable Subordination –Burden of Proof A party seeking equitable subordination must prove all of the required elements.

If the proponent of equitable subordination establishes injury, the burden shifts to the creditor being subordinated to show that (1) the injury was discrete in nature, and (2) the court cannot determine the amount of harm done without undue complication

If the subordinated creditor shows the value of its claim exceeds the damage caused by its conduct, the court will likely limit equitable subordination to an appropriate partial amount. See Mobile Steel, 563 F.2d at 701 (“claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct”).

If the court cannot identify the nature and extent of the injury, it can subordinate the entire claim

Standard is heightened for non-insiders/non-fiduciaries

Proving that an outside creditor behaved inequitably in anticipation of a debtor’s bankruptcy is difficult as the interests of the outside creditor and the debtor are not necessarily aligned

Cases subordinating claims of creditors that dealt at arms’ length with the debtor are “few and far between.” In re Sentinel Mgmt. Grp., 728 F.3d 660, 669-70 (7th Cir. 2013)


Transferring Equitable Subordination Claims

Section 550(b) protects good faith transferees of transfers avoidable pursuant to Section 547(b).

Section 510(c) does not specifically provide for a “good faith” defense for purchasers of claims

However, an argument exists that the good faith defense under Section 550(b) is extended to claims purchasers in the claims transfer process for purposes of protecting against equitable subordination.

Enron Corp. v. Springfield Assocs., LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007)

Court reasons that Section 510(c) creates a personal liability for a creditor that acted inequitably, and Congress did not intend to punish an innocent transferee of the claim.

Whether equitable subordination travels with a transferred claim depends on the means of transfer

If a claim is “assigned” the equitable subordination travels with the claim; if a claim is “sold,” the transferor takes the claim free of the equitable subordination

But see In re KB Toys, Inc., 470 B.R. 331, 335 (Bankr. D. Del. 2012)(disagreeing with Enron, and holding that “a claim in the hands of a transferee has the same rights and disablilities as the claim had in the hands of the original claimaint.”)


Comparing Equitable Subordination and Recharacterization

Similarities:

Both permit the bankruptcy court to reorder distributions of the debtor’s assets

Both have undercapitalization as an element

Differences:

Equitable subordination is (or may be) partial while recharacterization impacts the entire claim

Equitable subordination looks at the parties’ harmful behavior whereas recharacterization only looks at the substance of a particular transaction


How to Avoid Equitable Subordination

Practice Pointers:

Keep transactions at arms’ length

Loans should be properly documented with interest rates, maturity dates and/or amortization schedules, provide for remedies, and be secured (if possible)

Adhere to the borrower’s governance procedures and the loan documents – lenders can rigorously enforce bargained-for contractual rights, even if net effect may potentially be detrimental to other constituents.

Nonetheless, lenders should consider how actions will impact the borrower’s other creditors

Insiders

Don’t lend money to undercapitalized or insolvent companies


How to Avoid Equitable Subordination

Anticipate litigation:

Retain and always copy counsel

Document all arms’ length negotiations

Conduct due diligence into solvency, borrower’s operations, and other contractual relationships

Respect corporate governance procedures

Consider potential witnesses ahead of time

Reminder: Telephones still work well as means of communication – not everything must be written down

Internal bank files, for example – before memorializing subjective comments in writing (particularly internal memos), assume that those comments are reproduced and posted in a courtroom as evidence of some bad intent by creditor.

Follow contractual remedies and record only legitimate objective facts and observations – perfectly valid reasons for pursuing a remedy may look less favorable when commentary is plastered up in court


Standing

Constitutional Standing to Assert Equitable Subordination Claims

Governed by general legal standing principles requiring:

(1) Injury in fact which is concrete and particularized and actual or imminent;

(2) The injury is fairly traceable to the challenged action of the defendant; and

(3) It is likely, as opposed to reasonably speculative, that the injury will be redressed by a favorable decision

A party has constitutional standing to assert an equitable subordination claim where:

They have asserted a claim against the debtor’s estate;

The claim would be eliminated or reduced based on another creditor’s inequitable conduct;

The injury is directly traceable to the inequitable conduct; and

The Bankruptcy Court has the power to subordinate the inequitable party’s claim


Standing

Prudential Standing

General Claims – Where there is no particularized injury and the claim could be brought by any creditor of the debtor, the trustee is the proper party to assert the claim

The creditors are bound by the outcome of the trustee’s action

A creditor’s committee cannot assert an equitable subordination claim for a particular creditor absent special court authorization

Particular Claims – Where a creditor has an interest uniquely affected by alleged inequitable conduct, the individual creditor has standing separate from the trustee


Pleading

Creditors asserting equitable subordination claims only need to comply with the general pleading standards of Fed. R. Civ. P. 8(a) (Fed. R. Bankr. P. 7008):

A short and plain statement of the grounds for the court’s jurisdiction;

A short and plain statement of the claim showing that the pleader is entitled to relief; and

A demand for the relief sought

A party seeking equitable subordination does not have to comply with the heightened pleading standard for fraud under Fed. R. Civ. P. 9(b)

Questions?

Eric W. Anderson

Parker Hudson Rainer & Dobbs LLP

303 Peachtree St NE

Suite 3600

Atlanta, GA 30308

D: 404.420.4331

[email protected]


mailto:[email protected]

Equitable Subordination and Recharacterization

SUBORDINATION OF EQUITY RELATED CLAIMS IN BANKRUPTCY

MARCH 4, 2020

Gary Kaplan

Farella, Braun + Martel LLP

34

Bankruptcy Code Section 510(b)(11 USC §510(b)):

•Provides that a claim (i) arising from rescission of a purchase or sale of a security of the debtor or its affiliate, or (ii) for damages arising from purchase or sale of such security or (iii) for reimbursement or contribution allowed on account of such claim “shall be subordinated to all claims or interests that are senior to or equal to the claim or interest represented by such security.”

35

Congressional Intent of §510(b)

• Intent: Treat claims based on stock or other equity interests as lower priority than claims based on debt .

• Consistent with bankruptcy priority scheme generally—secured claims, certain priority claims (usually unsecured), general unsecured claims, stock and other equity interests.

• Enacted to prevent stockholders from reaping benefits when corporation performs well, but then asserting rights as creditors when it performs poorly (e.g., claims for fraud, rescission)

• 510(b) codifies case law, including Pepper v. Litton, 308 U.S. 295 (1939)

• Legislative history makes clear that §510(b) not intended to limit court’s equitable subordination powers (pursuant to §510(c))

36

Practical Implications of Subordination

•Bankruptcy priority scheme: creditor claims generally must be fully repaid before equity interests recover anything.

•Bankruptcy estates rarely have sufficient funds to repay all creditor claims.

•Practical effect of subordination under §510(b) is claimant often receives nothing for claim based on securities sale.

37

Subordination Disparate Impact Depending on Type of Equity Interest

• §510(b) provides that a claim subject to subordination under this statute “shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.”

• So, subordination of claims based on purchase or sale of common stock are subordinated so that they are treated as having same priority as common stock.

• But subordination of claims based on purchase or sale of other ownership interests (e.g., partnership interest, membership interest in LLC and the like) are subordinated so that they are below such ownership interests (one rung down), so even lower chance of receiving anything as hire tier must be fully repaid first.

38

Application of §510(b) by Courts

• §510(b) is mandatory, not permissive (as with equitable subordination under §510(c))

• However, courts can effectively use their discretion to determine whether it is applicable, as we will see from reviewing some of the reported case law.

• Application by bankruptcy courts and higher courts ruling on appeals from bankruptcy courts reflect that statute not interpreted uniformly

39

Subordination of Judgment Based on Equity Interest

• In re Tristar Esperanza Properties, LLC, 782 F.3d 492 (9th Cir. 2015):

• Subordinating claim under §510(b) based on judgment resulting from arbitration award on claim against LLC for repurchase of membership interest pursuant to LLC agreement.

•Whether claim is debt or equity when bankruptcy filed not dispositive; rather, key is claim’s nexus with purchase or sale of a security.

40

Employee Compensation Payable in Stock Subordinated

• In re Lehman Brothers Holdings Inc., 855 F.3d 459 (2d Cir. 2017):

•Employee claims based on restricted stock units (contingent right to purchase common stock; similar to options) received as compensation subordinated

•Receipt of RSUs in exchange for labor constituted “purchase” of securities.

41

Employee Compensation Payable in Stock Subordinated

•GSE Environmental, Inc. v. Sorrentino (In re GSE Environmental, Inc., No. 16-616 (D. Del. Nov. 15, 2017):

•CEO’s claim for unpaid compensation payable in stock subordinated under §510(b).

•Stock exchanged for labor constitutes equity security rather than debt claim based on employment agreement breach.

42

Dividend Based Claim Subordinated

•French v. Linn Energy, L.L.C. (In re Linn Energy, LLC), 936 F.3d 334 (5th Cir. 2019):

•Claim based on “deemed dividends” subordinated under §510(b).

•Contractual payments by corporation each time dividends paid to shareholders were more like equity interest than creditor debt, including unlimited upside.

43

Contribution Claims Arising from Securities Purchase Subordinated

•ANZ Securities, Inc. v. Giddens (In re Lehman Bros. Inc.), 808 F.3d, 942 (2nd Cir. 2015):

•Subordination of reimbursement and contribution claims of co-underwriters of debtor’s affiliate in defending investor lawsuits

•Subordinated to claims of debtor’s other creditors (although securities issued by debtor’s affiliate), per statutory language.

44

Claim Based on Guaranty of Affiliate’s Securities Subordinated

• In re American Housing Foundation, 785 F.3d 143 (5th Cir. 2015):

•Creditor’s guaranty claim arising from equity investments in debtor’s affiliate treated same as equity investments in debtor itself — i.e., subordinated to claims of general creditors,

•Debtor guaranteed investments in limited partnerships in which it was GP (or its parent).

45

§510(b) Subordination Applicable to Individual Debtors

• In re Del Baggio, 834 F.3d 1003 (9th Cir. 2016):

•§ 510(b) subordination provisions applicable when debtor is individual, even though individual cannot issue stock in himself.

•Claim based on debtor’s embezzlement of funds intended for group investment.

•Overruling 9th Cir. BAP and agreeing with In re Lehman Brothers, 808 F.3d 942 (2d Cir. 2015).

46

No Subordination of Stock Conversion Claim

• Khan v. Barton (In re Khan), 846 F.3d 1058 (9th Cir. 2017):

• Damage award against individual debtors for conversion of stock not subordinated as not deemed to arise from purchase or sale of securities, although based on wrongful cancellation of investor’s stock, and based on stock value at time of conversion.

• Apparently resulted-oriented decision: other founders unilaterally cancelled shares of co-founder after he had stroke and took leave of absence from corp.

47

No Subordination of Claim Indirectly Related to Sale of Security

• CIT Group Inc. v. Tyco Int’ l, Inc. (In re CIT Group Inc.), No. 12-1692 (2d Cir. 2012):

• Mere connection between claim and security purchase/sale doesn’t require subordination.

• Subsidiary of Tyco purchased CIT. Tyco sought to sell all of the equity interests in CIT in an initial public offering. In connection with the IPO, Tyco entered into a tax agreement with CIT, under which Tyco agreed to indemnify CIT against certain tax burdens arising from the Tyco subsidiary's purchase of CIT. CIT agreed to repay Tyco for any tax benefits resulting from the CIT's use of the Tyco subsidiary's net operating losses. After CIT filed for bankruptcy, it rejected the tax agreement. Tyco then filed a claim for breach of the tax agreement, which CIT sought to subordinate under §510(b).

• Court found that claim based on repayment of tax benefits resulting from use of affiliate’s NOL’s related to affiliate’s purchase of debtor’s securities does not arise from securities sale under §510(b), so not subordinated.

48

No Subordination of Membership Units in SPVs Holding Debtor Securities

• In re FAH Liquidating Corp., 563 B.R. 160 (Bankr. D. Del. 2017) [Fisker Automotive case]:•Membership units in special purpose vehicles

holding securities of debtor outside scope of §510(b) as not securities of debtor or affiliate.• SPV established by placement agent for debtor

financing (preferred stock issuance) but no direct connection with debtor.• Placement agent engaged by Fisker executed sub-

placement agreement with entity that issued membership units

49

Practice Tips

• Strategic investor seeking to reap benefits of ownership while preserving potential rights as creditor (and thus avoid subordination under §510(b)) can structure transaction based on lessons from case law

• Rather than acquiring direct interest of securities of company that is or may become distressed, create special purpose vehicle that is not an affiliate of the debtor holds securities of debtor, and issues membership units neither issued nor controlled by debtor

• Provide alternative compensation mechanism based on debt rather than equity (reverse conversion feature)

• Underwriters might want to seek stand alone indemnity agreement with co-underwriters and issuers, with separate source of claim payment (e.g., reserve from proceeds of issuance)

50

Questions?

Gary M. Kaplan

Farella, Braun + Martel LLP235 Montgomery Street17th FloorSan Francisco, CA 94104

D: [email protected]

51

© 2020 BLANK ROME LLP. ALL RIGHTS RESERVED. PLEASE CONTACT BLANK ROME FOR PERMISSION TO REUSE.

March 4, 2020

Recharacterization

Understanding the Law and Some Practical Guidance

Presented By: Ira L. Herman, Esq.

https://advance.lexis.com/api/document?collection=analytical-materials&id=urn:contentItem:5MY4-SY71-F06F-22F2-00000-00&context=


I. Introduction

• To increase their share of a finite bankruptcy pie, creditors, debtors and other parties in interest in a bankruptcy case will often challenge the validity and amount of competing claims. The Bankruptcy Code provides objecting parties with a robust “tool box” to accomplish this task.

53


II. The Statutory Predicates for Recharacterization

• Section 502(b)(1) of the Bankruptcy provides the authority for a party in interest in a bankruptcy case to object to a claim asserted by a competing creditor (a) by challenging the claim under bankruptcy and non-bankruptcy law, and (b) by the enforcement of any agreement between or among the parties giving rise to such claim.

• Section 510(c) of the Bankruptcy Code permits the equitable subordination of a claim where such claim arises from or is tainted by the inequitable conduct of a party.

54



• Subordination does not eliminate claims; rather, it results in the subordinated claim being removed from one class of claims and being placed in a class of claims that is afforded a lower priority in the pecking order of the payments to be made in a bankruptcy case.

55



• By the subordination of a claim and its removal from a class of claims, claims remaining in the class will benefit by receiving their proportionate share of a distribution that otherwise would have been paid on account of the now subordinated claim.

• In other words, all though the “size of the pie” remains the same in terms of dollars available for distribution to the affected class of creditors, the total dollar amount of claims to be paid in that class is reduced.

56



• The Bankruptcy Code, however, is silent with regard to the recharacterization of a purported claim as something with a lower priority than a claim, i.e., an equity security interest.

➢ A “claim,” under section 101(5) of the Bankruptcy Code, includes the “right to payment, whether or not such rightis reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.”

57



• Because no section of the Bankruptcy Code expressly provides for recharacterization, it has been left to the courts to determine whether or not they have the authority to recharacterize. Most courts, when asked to consider recharacterization, have held that the bankruptcy courts have the authority to do so. However, there is a split among the courts that recognize recharacterization as to the legal authority permitting recharacterization.

58



• A majority of the courts authorizing recharacterization, including the Third, Fourth, Sixth, and Tenth Circuits, have found that bankruptcycourts may recharacterize pursuant to the broad equitable powers granted by section 105(a) of the Bankruptcy Code.

➢ In re SubMicron Sys. 432 F.3d 448, 454; 2006 U.S. App. LEXIS344 (3d Cir. 2006); Dornier Aviation (North America), Inc. v. Official Comm. Of Unsecured Creditors (In re Dornier Aviation), 453 F.3d 225, 231; 2006 U.S. App. LEXIS 16101 (4th Cir. 2006); Sender v. Bronze Group, Ltd. (In re Hedged-Investments Assocs., Inc.), 380 F.3d 1292, 1297; 2004 U.S. App. LEXIS 18164 (10th Cir. 2004); In re AutoStyle Plastics, Inc., 269 F.3d 726, 748, 750; 2001 U.S. App. LEXIS 22602 (6th Cir. 2001).

59



• The Fifth and Ninth Circuits, have found that, recharacterization is required in appropriate circumstances by Butner v. United States, 440 U.S. 48, 54; 1979 U.S. LEXIS 58 (1979) when applicable non-bankruptcy law would treat something that at first glance may look like a loan, or which is labeled as a loan, as a contribution to capital.

➢ In re Lothian Oil, Inc., 650 F.3d 539, 542-43; 2011 U.S. App. LEXIS 16404 (5th Cir. 2011); Official Comm. Of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141, 1148; 2013 U.S. App. LEXIS 8229 (9th Cir. 2013).

60



• The Seventh Circuit is an outlier with respect to recharacterization, as it has not “definitively stated whether [it] recognize[s] a cause of action for recharacterization. FCC v. Airadigm Commc’ns, Inc. (In re Airadigm Commc’ns, Inc.), 616 F.3d 642, 657n.11 (7 th Cir. 2010).

• However, the Seventh Circuit has acknowledged that other circuits that have decided the issue have permitted recharacterization in appropriate circumstances.

61



• One potential result of the differing approaches employed by the circuits is forum shopping.

• Parties with questionable “loans” to companies that have a choice of venue may seek to have the borrower/debtor file for bankruptcyrelief in a jurisdiction where the authority of a bankruptcy court to order recharacterization is limited or uncertain.

• Another potential consequence is that the U.S. Supreme Court may be called upon to address the split if the “right” case comes along.

62


III. The Eleven Factors Considered by Courts that RecharacterizePursuant to the Broad Equitable Powers Granted by Section 105(a)

• In AutoStyle, the Sixth Circuit held that a bankruptcy court has the inherent power to recharacterize a claim as an equity interest since bankruptcy courts have judicial authority to use their equitable powers to allow or disallow claims.

• Using Roth Steel Tube Co. v. Comm’r of Internal Revenue as a guide, the Sixth Circuit developed eleven factors to be considered when determining whether a bankruptcy court should recharacterize a claim as an equity interest.

63



1. The wording used in the instruments evidencing the indebtedness

2. The presence of a fixed maturity date and schedule of payments

3. The presence of a fixed rate of interest and schedule of interest payments

4. The source of repayments (whether they are fixed or tied to the success of the business)

5. The adequacy of capitalization

6. The identity of interest between the creditor and the stockholder (or holder of a similar ownership interest

64



7. The security for repayment of the loan

8. The borrower’s ability to obtain financing from outside lending institutions (as opposed to from an Insider or Affiliate, as those terms are defined in Section 101 of the Bankruptcy Code

9. The extent to which repayment is subordinated by the operative documents to the repayment of debts payable to other creditors of the borrower

10. The extent to which an advance was used to acquire capital assets

11. The presence of a sinking fund to provide repayments

65



• Although the Fifth Circuit applied state law to recharacterize and disallow a claim under 502(b)(1) of the Bankruptcy Code in Lothian Oil, the court analyzed the agreement in question using an analytical model that was virtually indistinguishable from the 11-factor test used by courts that recharacterize using their general equitable powers.

➢ See, e.g., Sender v. Bronze Group, Ltd. (In re Hedged-Invs. Assocs. Inc.), 380 F.3d 1292, 1298; 2004 U.S. App. LEXIS 18164 (10th Cir. 2004) (citing multiple other cases; citations omitted).

66



• Where, as in Texas, applicable state law directs the court to apply the prevailing multi-factor test, the results achieved in the Fifth and Ninth Circuits are likely to be substantially similar to the results reached by courts that recharacterize pursuant to section 105(a) and employ the 11-factor analytical model.

67



• When a loan complies with the formalities for a valid loan agreement and the advanced funds are treated as a loan in the borrower’s business records, courts typically are reluctant to recharacterize a loan as an equity contribution, even when the borrower was undercapitalized.

• In SubMicron Systems, 434 F. 3d at 457, for example, the court concluded that an existing lender’s loan to an undercapitalized debtor had been properly characterized as a debt when the lending documents called the advances debt and established a fixed maturity date and fixed interest rate. Although the company was undercapitalized, the court concluded that the loan had been made to the distressed company in an attempt to protect the lender’s existing loans.

68


IV. Conclusion and Some Practical Guidance

• Different courts view recharacterization in different ways. The analysis is fact-intensive and has not always been consistent.

• Parties entering into a transaction must be aware of the recharacterization risk and document their transactions appropriately to achieve the desired outcome.

69



• The Lothian Oil decision is important because variations between state laws could yield different outcomes in recharacterization cases based on underlying state law, i.e., cases litigated in the Fifth and Ninth Circuits.

• For example, in Lothian Oil, although the district court found that it could not recharacterize non-insider debt claims under federal law, the Fifth Circuit reversed, because Texas law had no per se rule limiting recharacterization to the claims of insiders.

70



• A decision from the United States Bankruptcy Court for the Eastern District of Tennessee Southern Division is instructive. Paris v. SSAB Enters. LLC (In re SIAG Aerisyn, LLC), 2014 Bankr. LEXIS 4586, *5 (Bankr. E.D. Tenn. Nov. 3, 2014).

• What makes SIAG so interesting is its clear and focused application and analysis of the evidence in relation to each of the eleven AutoStyle factors.

• The Fifth Circuit decision in Lothian Oil is similarly instructive.

• Thus, these cases provide useful guidance for (a) transactional lawyers when they document a deal, and (b) bankruptcy lawyers, trial lawyers, and the courts when they next face a contest regarding the status of an advance and are asked to answer the question — is it a debt or really a capital contribution?

71



• Although several of the AutoStyle factors cannot be altered at the time a transaction is being documented and closed (e.g., the identity of the creditor with the shareholder and the participation of the creditor in management) other factors can indeed be controlled.

72



• As a practical matter, and consistent with the lessons of SIAG and Lothian Oil, a party making an advance intended to be paid back as a loan would be well served to:

➢ Back up the loan with formal documentation, including a standard promissory note

➢Make the loan only on normal business terms by imposing an interest rate and payment terms comparable to those which could be obtained from a unaffiliated lender –and–

➢ Avoid terms that are red flags for claim recharacterization, such as:

❖ A contingency on the obligation to repay

❖ Redemption provisions –and–

❖ Provisions granting voting power to the note holder

73


V. Questions

74

© 2020 BLANK ROME LLP. ALL RIGHTS RESERVED. PLEASE CONTACT BLANK ROME FOR PERMISSION TO REUSE. 75

Ira Herman concentrates his practice on restructuring and bankruptcy matters with emphasis on distressed public debt issues and distressed M&A. Ira regularly advises lenders and other clients on the management of bankruptcy risk in their transactions; indenture trustees regarding defaulted public debt issues; and lenders regarding restructuring and bankruptcy, including distressed M&A transactions and inter-creditor issues. Additionally, he provides services on the debtors’ side, counseling financially distressed entities and their management on restructuring challenges pertaining to corporate governance issues, and litigating corporate governance matters, such as breach of duty in good faith and dealing. As a court appointed mediator, Ira has been able to facilitate the resolution of controversies involving U.S. and non-U.S. parties concerning bankruptcy and commercial law issues.

In addition to his restructuring and bankruptcy practice, Ira has been providing support to for-profit and nonprofit entities concerning data privacy and cybersecurity issues.

Ira L. [email protected]

equitable subordination and recharacterization of loans...

Documents